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Fannie and Freddie, still in need of breastfeeding.

August 25th, 2017 12:22 pm | By admin | Posted In Credit

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Fannie Mae and Freddie Mac, two of the largest government-sponsored enterprises (GSE) of the country were recently put under some stress, to test how good they’ll perform if the global economic scenario suffers a severe setback.

 

An assessment known as the Dodd-Frank Act Severely-Adverse Scenario Test (did you get that?), which is derived from the well-known Dodd-Frank Wall Street Reform and Consumer Protection Act, must be implemented at certain financial companies with more than $10 billion in consolidated assets.

 

This was one of the regulatory tools established after the severe impact that the global financial crisis of 2007-2008 had on these two giants. Politicians expect from this assessment an answer to the question: Will they survive another one?

 

The test is like throwing two eggs as hard as you can against the floor, to see if they hatch. I mean, the assumptions under which this stress test functions are so severe that under such scenarios, politicians might be more concerned about whether the whole-economy survival, rather than just Fannie and Freddie.

 

Nevertheless, I guess that’s the average crisis-paranoia level we are comfortable with right now, given the not-that recent events.

 

You might find these assumptions to be something like: If the whole world suddenly goes back to the 1950s, would Fannie and Freddie survive?

 

According to The Federal Housing Finance Agency (FHFA), the institution in charge of carrying out these stress tests, the assumptions include: “large reductions in asset prices, significant widening of corporate bond spreads, and strained market liquidity conditions”.

 
Some of this ‘what if’ conditions are:

• A 6.5% decline in the GDP.
• A rate of unemployment of 10%.
• An inflation rate of 1.75%
• Near-zero short-term Treasury interest rates.
• A sharp decline in asset prices, as financial conditions are severely stressed.
• Mounting credit losses.
• Equity prices fall by 50%
• Volatility levels are the same as in 2008.
• Home prices decline by 25%
• Commercial real estate prices fall by 35%
• You stop reading this list and hide in the bathroom until it’s all over.

 
Pretty harsh isn’t it? Let’s hope we don’t get to that, again.

 

So, after explaining what these tests are all about, let’s review what were the recent results obtained from the last one applied to both enterprises, by looking at the report released by the FHFA a few days ago.

 

Since the 2008 crisis, these GSEs were put under “conservatorship” because of their declining sustainability. Under this scenario, the Treasury is committed to provide support to both Fannie and Freddie in order to keep them healthy enough to sustain their operations within the real estate market.

 

To explain this easier, let’s use some mommy-and-daddy language. The Treasury is like Fannie and Freddie’s mom. Somehow unnaturally, they were both grown-ups but they managed to mess everything up sooo much, that they now have to be cared for all over again, back to breastfeeding stages.

 

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What the FHFA’s recent report unveils is that, under these stressful conditions, they are still in need of breastfeeding. At least for a while, a big-while it seems though.

 

A combined evaluation of both enterprises reveals that, if such apocalyptic scenario took place, they will require from $35 to $100 billion dollars from the Treasury Department to keep breathing after experiencing massive losses derived from all the hell-broke-loose economic setbacks that we described above.

 

It sounds like a lot of money, but it is actually almost 25% less than what they needed last year. Are you feeling less worried about it? You shouldn’t.

 

These institutions need to be redesigned towards a sustainable model where breastfeeding is no longer required. Right now, the size of the breastfeeding is $258 billion and according to this report, it will be difficult to wean both of them, since they have no capital to withstand potential losses coming from adverse market environments.

 

Mell Watt, the Director of the FHFA, has a difficult task ahead to convince politicians that a more sustainable approach needs to be implemented, before a Treasury draw has to take place. Let’s hope he can do it. Meanwhile, stay tuned, your taxes are still being relied on to keep things going.

 

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